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Don’t Be Fooled by the Fed’s Taper Talk

Question: Suppose the Fed doubles the supply of ”high-powered money” (monetary base) from around 15 percent to 30 percent of US GDP over a period of less than two years, then announces that the pace of increase will slow to just above zero within the next year providing that the economy remains “on course”; does this amount to a serious attenuation of monetary inflation?

Answer: No.

The Fed’s prospective “taper,” now the endless subject of the twenty-four-hour financial TV news cycle, provides a case study for explaining this response.

The US central bank, on course to deliver this year a record amount of inflation tax revenue to the federal government, is now using all its instruments of propaganda to tell us about its looming “monetary normalization” program, otherwise described as “tapering.” An ostensible aim is to keep markets calm. 

By the time the gradually preannounced six- or nine-month wind down in the Fed’s asset purchases gets underway we should all be prepared. The Jackson Hole conference (August 26–28) completes the process of getting us ready. The calming information which features in the preannouncements is designed to foster a continuous smooth adjustment rather than any shock response.

So far, top Fed officials are most likely congratulating themselves on a job well done.

Although by now everyone and their dog knows that the Fed intends, on the basis of present economic projections, to stop further net purchases of bonds by summer 2022, there has been no steep sell-off in US long-term rate markets or more widely. That is different from the notorious days preceding and during the Bernanke Fed’s tapering of 2013–14. 

Reality check: the calmness is not due to Fed communication skill but to the fact that hardly anyone now, unlike in that earlier episode, misguidedly views tapering as a preparation for the end of monetary inflation.

Even so, market analysts in and outside the Fed are understandably wary of what we could describe as “emperor’s new clothes effects.” This is where investors and traders are fearful that others might actually believe in the monetary normalization story. Hence there is some cautious position squaring or equivalent when any announcement about Fed tapering features in “breaking news.”

The real news is that there will be no rebate, albeit spread over a long period of time, of this year’s inflation tax levy, as would occur under monetary normality, if that meant soundness.

This year’s inflation tax (where the rate of tax is defined as the amount by which Consumer Price Index [CPI] inflation exceeds expectations) has largely been levied by outside forces—sudden scarcities of goods as the pandemic recedes amidst bottlenecks of various forms. These price jumps are the immediate explanation for why the purchasing power of the dollar this year will have fallen by 5 percent or more compared to forecasts at the beginning of the year of under 2 percent. This surprise inflation overshoot of 3–4 percentage points is the inflation tax rate levied in 2021 on all direct and indirect holdings of US government paper, whose principal is fixed in dollars. 

Under any seriously sound money regime, that inflation tax would have been balanced by prospective rebates based on the expectation of price reductions over the long run; automatic mechanisms would have rolled prices back towards a long-run unchanged mean. But these do not operate now. Instead at each opportunity leading Fed officials tell us that they will aim for goods and services inflation to run at 2 percent next year and beyond, rather than allowing the rollback which would have produced the rebate. 

Any serious normalization now would have mimicked at least in part the operation of the automatic mechanisms under sound money. These would have included some rise in money market rates as the supply of money in real terms contracted in consequence of the price spikes.

Instead, the Fed has been operating with its corrupted monetary system to pin money rates at zero whilst manipulating long-term rates downwards. It promises that there will be no rise in rates until winter 2022/23.

Some commentators suggest that long-term rates might rise due to less Fed purchases of government bonds. This is implausible, given that the prices of these are determined by supply and demand related to the stock of bonds outstanding. The Fed will still be a huge holder of this stock, hence continuing to weigh down on the so-called term premium.

There is a more general point to make here about stocks and flows.

We can define monetary inflation as a situation where the supply of money outstanding, most of all in high-powered form, is well in excess of any estimation of long-run trend demand for this in real terms. This excess, in turn, may be the cause of upward pressure of prices in goods and services markets. However, if there is widespread economic sclerosis or powerful nonmonetary disinflationary forces are operating, then symptoms of monetary inflation would be most of all in asset markets. Slowing down the new supply of high-powered money from a starting situation of big excess does not remotely mean the end of the monetary inflation.

Problem: in the present corrupted monetary system, high-powered money has been stripped of all its special properties which make it more money-like than other components of money. Hence, it has ceased to have unambiguous meaning for the diagnosis of monetary inflation.

Too big to fail, widespread and generous deposit insurance, and payment of interest on bank reserves have reduce high-powered money to a shadow of its importance under a classical monetary system. We can no longer make judgments about monetary inflation based on an analysis of supply and demand for high-powered money. 

Instead we have to scramble around the evidence of monetary inflation, whether in goods or asset markets, whilst delving into treacherous issues as to whether average market rates seem to be persistently above or below a theoretically unknown “natural rate.” 

So how to judge the Fed’s claim that its taper will be the start of the route towards “monetary normality”? 

The Fed denies in any case that monetary inflation has been underway? In that denial the Fed conveniently repudiates or ignores any concept of asset inflation. There is nothing in its announcements to suggest a change of purpose.

The cynic would suggest that the Fed’s prospective monetary policy fits into a typical political cycle.

Ahead of a difficult midterm election challenge in 2022, the Fed under its newly nominated or renominated chief will be using any opportunity provided by a fallback of prices in the wake of bottleneck easing to justify its continued pinning of rates at zero. It will not allow the “natural rhythm” of prices to take CPI downwards. Crucially, this pattern of monetary inflation in 2022 could mean some catch-up of nominal wages, which could rise substantially in real terms. 

It has been the loss of real income due to price spikes from bottlenecks, rather than the levying of inflation tax, which has apparently stimulated resentment to inflation in 2021. Many individuals console themselves about the 2021 inflation tax levy, if they even think about it, by contemplating heady gains they have made to date in consequence of virulent asset inflation.

A wild card in any such political calculations is the potential for sudden reversal of asset inflation brought about by endogenous forces strengthened by a long monetary inflation—whether credit deterioration or fading speculative narratives or waning prosperity amidst cumulative malinvestment.

History will judge whether the advice on monetary matters which the Biden administration is seeking and acting on is any better or worse than on Afghanistan.